# EMPIRE PETROLEUM CORP (EP) FY 2023 MD&A Verbatim Item 7 Management's Discussion and Analysis from EMPIRE PETROLEUM CORP's 10-K for fiscal year 2023. SEC filing source: https://www.sec.gov/Archives/edgar/data/887396/000107261324000353/empire_form10k123123.htm Accession: 0001072613-24-000353 Filing date: 2024-03-28 Report date: 2023-12-31 Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary. Confidence: high Company profile: /company/EP/ All MD&A years: /company/EP/mda/ Previous year: /company/EP/mda/fy2022/ (FY 2022) Next year: /company/EP/mda/fy2024/ (FY 2024) ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following discussion should be read together with the consolidated financial statements and notes to consolidated financial statements, which are included in this Annual Report on Form 10-K in Item 8, Financial Statements and Supplementary Data, and the information set forth in Part I, Item 1A – Risk Factors. Overview Our primary business is the optimization and development of oil and gas interests. In 2022 we had net income from operations but have incurred losses from operations in 2023 and in years prior to 2022. There is no assurance that we will be profitable or obtain funds necessary to finance our future operations. We seek to increase shareholder value by growing reserves, production, revenues, and cash flow from operating activities by executing our mission to use highly-skilled personnel to thoughtfully and expertly spend capital to realize reserves on producing properties as well as further develop fields. Management places emphasis on operating cash flow in managing our business, as operating cash flow considers the cash expenses incurred during the period and excludes non-cash expenditures not related directly to our operations. Production and Operating Data The following table sets forth a summary of our production and operating data for the years ended December 31, 2023 and 2022. [[GREPCENT_TABLE]] [["","","Year Ended December 31, 2023","","","Year Ended December 31, 2022"],["Production and operating data:"],["Net sales volumes:"],["Oil (Bbl)","","","487,869","","","","482,818"],["Natural gas (Mcf)","","","854,274","","","","875,647"],["Natural gas liquids (Bbl)","","","136,013","","","","160,809"],["Total (Boe)","","","766,261","","","","789,568"],["Average price per unit:"],["Oil (a)","","$","75.19","","","$","93.16"],["Natural gas","","$","2.02","","","$","5.18"],["Natural gas liquids","","$","12.21","","","$","22.76"],["Total (Boe)","","$","52.29","","","$","67.34"],["Operating costs and expenses per Boe:"],["Lease operating expense (excluding workovers)","","$","21.70","","","$","19.92"],["Workovers","","$","15.66","","","$","9.95"],["Total Lease operating expense","","$","37.36","","","$","29.87"],["Production and ad valorem taxes","","$","3.97","","","$","4.99"],["Depreciation, depletion, amortization and accretion","","$","6.33","","","$","4.19"],["General & administrative (excluding stock-based compensation)","","$","15.71","","","$","12.18"],["Stock-based compensation","","$","4.10","","","$","3.44"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","(a)","Excludes the effect of net cash receipts from (payments on) derivatives."]] [[/GREPCENT_TABLE]] Business Strategy Our business strategy is to obtain long-term growth in reserves and cash flow on a cost-effective basis. Management regularly evaluates potential acquisitions of properties that would enhance current core areas of operation. 25 Results of Operations The following table reflects our summary operating information. Because of normal production declines, increased or decreased drilling activity and the effects of acquisitions, the historical information presented below should not be interpreted as indicative of future results. [[GREPCENT_TABLE]] [["","","Years Ended December 31,"],["","","2023","","","2022","","","$ Variance","","","Variance %"],["Oil revenues","","$","36,684,494","","","$","44,978,554","","","","(8,294,060",")","","","-18%"],["Natural gas revenues","","","1,726,754","","","","4,534,370","","","","(2,807,616",")","","","-62%"],["NGL revenues","","","1,660,256","","","","3,659,451","","","","(1,999,195",")","","","-55%"],["Total product revenues","","","40,071,504","","","","53,172,375"],["Lease operating expense","","","28,625,481","","","","23,584,039","","","","5,041,442","","","","21%"],["Production and ad valorem taxes","","","3,044,411","","","","3,943,466","","","","(899,055",")","","","-23%"],["Depreciation, depletion, amortization and accretion","","","4,852,555","","","","3,307,097","","","","1,545,458","","","","47%"],["Impairment","","","\u2014","","","","936,620","","","","(936,620",")","","","-100%"],["General and administrative expense (excluding stock-based compensation)","","","12,034,184","","","","9,614,948","","","","2,419,236","","","","25%"],["Stock-based compensation","","","3,144,751","","","","2,716,541","","","","428,210","","","","16%"],["Cash-based interest expense","","","650,637","","","","473,205","","","","177,432","","","","37%"],["Non-cash interest expense","","","349,790","","","","36,335","","","","313,455","","","","NM"],["Operating Income (Loss)","","","(11,625,091",")","","","8,784,163","","","","(20,409,254",")","","","NM"],["Net Income (Loss)","","","(12,469,605",")","","","7,084,130","","","","(19,553,735",")","","","NM"]] [[/GREPCENT_TABLE]] NM: A percentage calculation is not meaningful due to change in signs, a zero-value denominator or a percentage change greater than 200. Revenues Revenues for 2023 decreased compared to the prior year primarily due to lower realized oil, natural gas and NGL prices and lower NGL volumes, partially offset by higher oil volumes in North Dakota. Realized oil prices for 2023, were approximately $75.19 per barrel, while realized prices for the prior year were approximately $93.16 per barrel, a decrease in price of approximately 19%. Oil volumes were higher by approximately 5,000 barrels primarily due to increased production in North Dakota partially offset by lower production in New Mexico. Realized natural gas prices for 2023, were approximately $2.02 per Mcf, while realized prices for the prior year were approximately $5.18 per Mcf, a decrease in price of approximately 61%. Realized NGL prices for 2023, were approximately $12.21 per barrel, while realized prices for the prior year were approximately $22.76 per barrel, a decrease in price of approximately 46%. NGL sales volumes were lower in 2023 compared to 2022 primarily due to lower volumes in New Mexico. Lease Operating Expense and Production Taxes Lease operating expense was higher in 2023 primarily due to higher workover activities. Lease operating expense includes approximately $12.0 million of workover expense for 2023 as compared to approximately $7.9 million for 2022. Workover expense in New Mexico increased due in part to a higher level of compliance-related activities. In addition, workover expense in North Dakota was higher for 2023 as the Company continued to work over wells in the state to enhance production alongside capital recompletions and sidetrack drilling started in 2022. Production taxes were lower for 2023 compared to 2022 as a result of the lower product revenues discussed above. Depreciation, Depletion, Amortization and Accretion and Impairment The higher DD&A in 2023 as compared to 2022 primarily related to a higher depletable basis from capital expenditures in 2023. Accretion expense was higher in 2023 as the overall obligation increases over time. We assess our oil and gas properties for impairment when circumstances indicate the carrying value may be greater than its estimated future net cash flows. In 2022, estimated future cash flows from our properties in Louisiana were less than the net book value. As a result, we recorded a $936,000 impairment expense. 26 General and Administrative Expense (excluding stock-based compensation) General and Administrative Expense (excluding stock-based compensation) increased primarily due to higher employee expenses related to increased headcount in 2023 compared to 2022 and $505,000 related to severance expense for two executives in 2023 (See Note 14 of Notes to Consolidated Financial Statements). Board compensation expense, exclusive of stock-based compensation, was approximately $588,000 in 2023 as compared to $388,000 in 2022. In addition, 2023 expenses were higher due to legal costs related to potential financing transactions and compliance work related to our New Mexico operations. In 2022, we recognized expenses totaling approximately $1,269,000 in conjunction with resolution of a Texas sales tax audit for prior periods for which the initial assessment was received in April 2022. This total includes consulting fees and an accrual for $528,000 for the final settlement which was paid in 2023. Stock-based Compensation We utilize stock-based compensation to compensate members of management and retain talented personnel. Our stock-based compensation increased in 2023 due to a higher number of awards in 2023. We anticipate stock-based compensation to continue to be utilized in 2024 and beyond to attract and retain talented personnel and compensate our board members and consultants. Interest Expense Cash-based interest expense increased as higher interest rates were partially offset by a lower outstanding balance under our Credit Facility. We have minimal interest-bearing vehicle and equipment notes payable. Non-cash interest expense is primarily attributable to the related party note payable as described in Note 7 of Notes to Consolidated Financial Statements. In addition, 2023 includes interest from $10,000,000 of bridge loans from related parties that were subsequently converted to equity (See Note 15 of Notes to Consolidated Financial Statements). Income taxes We have generated net operating losses since inception, which would normally reflect a tax benefit in the consolidated statement of operations and a deferred asset on the consolidated balance sheet. However, because of the current uncertainty as to our ability to achieve sustained profitability and the potential limitation of NOL carryforwards, a valuation reserve has been established that offsets the amount of any tax benefit available for each period presented in the consolidated statements of operations. For 2023, we had a loss before income taxes for which the tax benefit was offset by a change in valuation allowance. For 2022, we had income before income taxes which resulted in a tax provision that was offset by a change in the valuation allowance due to the anticipated use of the NOL carryforward and intangible drilling costs. For 2023 and 2022, our effective tax rates were 1% and 3%, respectively. Liquidity As noted below, our working capital is negative as of December 31, 2023 and is primarily a result of a higher level of payables related to capital spending in North Dakota. In addition, the Company was not in compliance with the current ratio covenant under its Credit Facility as of December 31, 2023; however, the Company obtained a compliance waiver from the lender for December 31, 2023. As of December 31, 2023, we had approximately $8 million in cash on hand and approximately $5.5 million available on the Credit Facility. For additional information regarding the Credit Facility, see Note 7 of Notes to Consolidated Financial Statements. The Company will require additional funds to satisfy these payables related to the capital spending program which are greater than estimated cash flows from operations over the next 12 months. Management has initiated plans to raise the necessary funds including the commencement of a rights offering expected to raise up to approximately $20.66 million (see Note 18 of Notes to Consolidated Financial Statements). Phil Mulacek and Energy Evolution Master Funds, Ltd, both related parties of the Company and largest shareholders collectively owning 46% of the common shares outstanding, have indicated that they intend to participate in the rights offering and fully subscribe to the shares of Common Stock corresponding to their subscription rights and intend to exercise their over-subscription rights. See Note 1 - Liquidity and Going Concern of Notes to Consolidated Financial Statements for further discussion of management’s plans. We expect to incur costs related to drilling activities in core areas.  It is expected that management will use a combination of cash on hand and cash flows from operations as well as seeking additional debt or equity funding to fund these ongoing activities. 27 Working Capital Working capital (presented below) was $(6.3) million as of December 31, 2023 compared to $5.1 million as of December 31, 2022, representing a change of approximately $(11.4) million. This change was primarily driven by payables related to the Starbuck Drilling Program. [[GREPCENT_TABLE]] [["","","As of December 31,"],["","","2023","","","2022"],["Current Assets","","$","18,744,904","","","$","22,734,973"],["Current Liabilities","","$","25,049,572","","","$","17,620,660"],["Working Capital","","$","(6,304,668",")","","$","5,114,313"]] [[/GREPCENT_TABLE]] Cash Flows [[GREPCENT_TABLE]] [["","","Year Ended December 31,"],["Cash flows provided by (used in):","","2023","","","2022","","","Variance"],["Operating activities","","$","(9,887,500",")","","$","18,055,783","","","$","(27,943,283",")"],["Investing activities","","","(14,767,339",")","","","(11,413,487",")","","","(3,353,852",")"],["Financing activities","","","20,502,905","","","","1,690,275","","","","18,812,630"]] [[/GREPCENT_TABLE]] Cash Flows from Operating Activities Cash flows from operating activities in 2023 was impacted by lower commodity prices and higher operating expenses compared to 2022, partially offset by higher oil volumes. Cash flow from operating activities in 2022 benefited from higher commodity prices and higher natural gas and NGL volumes. Cash Flows from Investing Activities Cash flows from investing activities in 2023 includes approximately $25 million of additions to oil and gas properties primarily due to the development of our operations in North Dakota, partially offset by approximately $9.9 million for a change in accounts payable related to capital expenditures. In 2022, we had approximately $11.4 million of additions to oil and gas properties primarily, partially offset by approximately $1.2 million for a change in accounts payable related to capital expenditures. In 2022, we began recompletions and other capitalizable efforts in multiple states as we sought to bring production online from existing wells and bring on new production from sidetrack drilling in North Dakota which led to an increase in additions to oil and natural gas properties in 2022. We also participated in the drilling of four non-operated wells through Empire Rockies Region in 2022 spending approximately $600,000. In 2022, we were able to negotiate for the release of the sinking fund requirement. Approximately $2.8 million and $2 million of the sinking fund balance was returned to us in 2023 and 2022, respectively. In addition, 2023 includes $2 million related to the acquisition of additional interest in our New Mexico oil and gas properties compared to $2.7 million of acquisitions in 2022. Cash Flows from Financing Activities In 2023, we received $10 million from related parties in the form of bridge loans which were subsequently converted to our common shares (See Note 15 of Notes to Consolidated Financial Statements). In 2023, we entered into a new revolving line of credit with Equity Bank (See Note 7 of Notes to Consolidated Financial Statements) and used approximately $4.5 million to retire the outstanding balance of our previous revolving line of credit with CrossFirst Bank. Principal payments made on our revolving line of credit with CrossFirst Bank were approximately $1.5 million and $1.2 million in 2023 and 2022, respectively. In 2023, we received approximately $12.5 million from stock issuances and warrant exercises. In 2022, we received approximately $3.4 million in cash from warrant exercises. Capital Resources Capital Expenditures For 2023, additions to oil and natural gas properties totaled $27 million including $2.1 million related to acquisitions. The $25 million not related to acquisitions primarily reflects development of our North Dakota operations. We anticipate capital expenditures in 2024 that will be funded with cash on hand, cash flows from operations, debt, and/or equity issuances. 28 Related Party Transactions In 2023, we received $10 million in bridge loan funds from Phil Mulacek and Energy Evolution Master Fund, Ltd., related parties, which were subsequently converted to our common shares. In addition, we sold shares to both parties and received $5 million in proceeds from each party. Both transactions are described further in Note 15 of Notes to Consolidated Financial Statements. These transactions were related party transactions for accounting purposes. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements. Critical Accounting Estimates The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosures of contingent assets and liabilities. Because estimates and assumptions require significant judgment, future actual results could differ from those estimates and could have a significant impact on our results of operations, financial position and cash flows. We re-evaluate our estimates and assumptions at least on a quarterly basis. In our management’s opinion, the more significant reporting areas impacted by management’s judgments and estimates are as follows: Successful Efforts Method of Accounting for Oil and Natural Gas Activities We use the successful efforts method of accounting for oil and natural gas operations. Under this method, costs to acquire oil and natural gas properties, drill successful exploratory wells, drill and equip development wells, and install production facilities are capitalized. Estimated proved oil and natural gas reserves, management’s outlook on commodity prices and projected future cash flows of oil and natural gas reserves are a significant part of our financial calculations. Following are examples of how these estimates affect financial results: [[GREPCENT_TABLE]] [["","\u00b7","an increase (decrease) in estimated proved oil, natural gas and NGL reserves can reduce (increase) our unit-of-production depletion and amortization rates; and"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u00b7","changes in the oil, natural gas and NGL reserves and the projected future cash flows from our properties can impact our periodic impairment analyses."]] [[/GREPCENT_TABLE]] Proved oil and natural gas reserves are the estimated quantities of oil, natural gas and NGLs which geological and engineering data demonstrate with reasonable certainty to be recoverable in future periods from known reservoirs under existing economic and operating conditions. Reserve quantities and future cash flows included in this report are prepared in accordance with guidelines established by the SEC and the Financial Accounting Standards Board (“FASB”). The accuracy of reserve estimates is a function of: [[GREPCENT_TABLE]] [["","\u00b7","The quality and quantity of available data;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u00b7","The interpretation of that data;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u00b7","The accuracy of various mandated economic assumptions; and"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u00b7","The judgments of the persons preparing the estimates."]] [[/GREPCENT_TABLE]] Proved reserves information included in this report is based on estimates prepared by independent petroleum engineers, Cawley Gillespie &Associates. The independent petroleum engineers evaluated 100% of our estimated proved producing reserve quantities and their related future net cash flows as of December 31, 2023. Estimates prepared by others may be higher or lower than these estimates. Because these estimates depend on many assumptions, all of which may differ substantially from actual results, reserve estimates may be different from the quantities of oil and natural gas that are ultimately recovered. Management may make revisions to reserve estimates throughout the year as additional information becomes available. Such changes could trigger an impairment of our oil and natural gas properties and have an impact on our depletion expense prospectively. For example, a change of 10 percent in our total proved reserves could change our annual depletion and amortization expense by $350,000. The actual impact would depend on the specific areas impacted. Impairment of Oil and Gas Properties We assess our proved properties for impairment using estimates of future undiscounted cash flows. This assessment requires significant judgment and assumptions including commodity price outlooks, estimates of reserve quantities, expected lease operating costs and capital costs. An impairment expense could result if oil and gas prices decline in the future as it may not be economic to develop some of these unproved properties. We performed an assessment as of December 31, 2023 and did not identify any impairments. 29 Asset Retirement Obligation Asset retirement obligations (“AROs”) consist primarily of estimated future costs associated with the plugging and abandonment of oil and natural gas wells, removal of equipment and facilities from leased acreage, and land restoration in accordance with applicable local, state and federal laws. The discounted fair value of an ARO liability is required to be recognized in the period in which it is incurred, with the associated asset retirement cost capitalized as part of the carrying cost of the oil and natural gas asset. The recognition of an ARO requires that management make numerous assumptions regarding such factors as the estimated probabilities, amounts and timing of settlements; the credit-adjusted risk-free rate to be used; inflation rates; and future advances in technology. In periods subsequent to the initial measurement of the ARO, we must recognize period-to-period changes in the liability resulting from the passage of time and revisions to either the timing or the amount of the original estimate of undiscounted cash flows. Stock-Based Compensation We recognize stock-based compensation expense associated with restricted stock units and options. We account for forfeitures of equity-based incentive awards as they occur. Stock-based compensation expense related to time-based restricted stock units is based on the price of our common stock on the grant date. Stock-based compensation related to options is the fair value of the option recognized over the vesting period. The fair value of an option is determined using the Black-Scholes option valuation with the following assumption inputs:  dividend yield, expected annual volatility, risk free interest rate and an expected life. Income Taxes and Uncertain Tax Positions Our tax provision is based upon the tax laws and rates in effect in the applicable jurisdiction in which operations are conducted and income is earned. As part of the process of preparing the consolidated financial statements, management is required to estimate the income tax provision. This process involves estimating the actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as depreciation, amortization and certain accrued liabilities for tax and accounting purposes. Deferred tax expense or benefit represents the change in the balance of deferred tax assets or liabilities. Valuation allowances are established to reduce deferred tax assets when it is more likely than not that some portion or all of the deferred tax assets will not be realized. At December 31, 2023 and 2022, a valuation allowance for deferred tax assets was recorded. Management applies the accounting standards related to uncertainty in income taxes. This accounting guidance clarifies the accounting for uncertainties in income taxes by prescribing a minimum recognition threshold that a tax position is required to meet before being recognized in the consolidated financial statements. It requires that we recognize in the consolidated financial statements the financial effects of a tax position, if that position is more likely than not of being sustained upon examination, including resolution of any appeals or litigation processes, based upon the technical merits of the position. It also provides guidance on measurement, classification, interest, penalties and disclosure. We have no uncertain tax positions at either December 31, 2023 or December 31, 2022.